Emerging Market Allocations

The empirical evidence about the connection between GDP growth and equity market performance might be bad news for the hapless market strategists trying to alter asset allocations to reflect new patterns of global growth.

The split in funds between emerging markets and advanced economy markets is one of the key equity market judgments being made by global investors. One rationale for a rising allocation to emerging markets is the likelihood that their output growth will be higher for the foreseeable future than in the advanced economies of north America, Europe and Japan.

This argument presupposes that equity markets will move in line with or be leveraged to GDP growth. At face value, this seems a reasonable enough proposition. In any market, profit growth will depend on a combination of price rises and output expansion. Everything else being the same, higher output should lift profits. Higher profits should translate into higher equity values.

There is an historical parallel to the current demise of one economic power and the emergence of new centres of economic influence. In the early twentieth century, the U.S. was an emerging market and the UK was the advanced industrial economy being overtaken by a better endowed and larger competitor in much the same way as China is catching up with, to possibly move ahead of, the USA.

For most of the century, the relative position of the UK declined. UK GDP expanded at a rate of 1.9% a year compared to 3.3% a year in the USA. Per capita output in the UK in 1900 was the same as U.S. per capita output. One hundred years later, UK per capita output was just 71% of the U.S. level. Sterling, at the same time, fell 69% against the U.S. dollar.

In 2002, Elroy Dimson, Paul Marsh & Mike Staunton published "Triumph of the Optimists: 101 Years of Global Investment Returns". Their data, compiled on a consistent basis across 16 countries, showed that in the 100 years from 1900, the U.S. equity market return of 10.1% a year was identical with the UK equity market return over the same period. In fact, on their analysis, the risk adjusted excess return in the UK was slightly higher than in the USA.

No doubt, other influences could be at work. However, to the extent that this history offers any form of guide, there is nothing to suggest that the current move by asset allocators to emerging markets will make a significant difference to investment performance.

This somewhat surprising conclusion comes despite the apparent alignment of the macroeconomic variables to which strategists normally point when arguing that funds held outside the USA are likely to perform better than those kept at home.

There are reasons why the anticipated difference in market performance could fail to reflect the macroeconomic indicators being used to justify the move.

Even in declining economies, new companies will be forming around new industries with relatively strong growth prospects.

Existing companies will seek to innovate production processes or products to maintain their competitiveness.

Companies in established economies will adapt to their changing business environment by investing in and servicing faster growing overseas markets.

The economy in relative decline might remain a less risky investment option, notwithstanding a decelerating growth path, so that even relatively low profits might be more highly valued than more volatile or less well understood profits sourced from emerging markets.

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